Lululemon - Quick, Cover Your Shorts!

After reporting a record fiscal third quarter, Lululemon Athletica (NASDAQ:LULU) continues to impress investors. Short sellers have been targeting this company for years, and although the stock has seen short term periods of price depreciation, the long term upward trend remains intact. Following the recent earnings release, it appears Lululemon is on track for robust growth in the years to come.

There have been numerous articles written on the stock following its fiscal Q3 earnings. "Lululemon Perhaps The Best Buy In Retail" does an excellent job analyzing the current quarter and performance in past quarters. Taking a moment to reflect on how management has performed in the past should provide a better understanding of piecing together what the future may hold. Rather than provide a recap on the quarter, the focus of this article will be on what I believe to be the two most important evaluation metrics, growth and cash flow.

Growth

A constant debate that comes to mind when discussing niche market companies like Lululemon circles around, "Are they just a fad, or a lasting business?". This question should undoubtedly cross your mind when evaluating this particular stock for your portfolio. Typically fads will balloon to the point of reaching all potential customers at various price points until the appeal of the product eventually fades away. I would urge potential investors to look at the core customers of the business and how the company caters to their needs and wants. Lululemon's target customer is a mid-30 year old female with a reasonable level of disposable income. The company has an aggressive advertising campaign in relevant publications in addition to periodic yoga sessions at familiar or historic landmarks (Upper West Side Riverside Church in New York, Peabody Hotel in Memphis, and Ohio State University to name a few). These creative events give consumers a strong sense of quality which attracts them to the brand.

The next step involves getting the customer into a store. Since 2002 the company's store count has grown at a compound annual growth rate of 45.28% (see table below). While this may seem rather rapid, it is a fairly conservative position in adding new locations. Rather than over expand, they are strategically placing stores in target markets where they feel the brand awareness will be best utilized. As of the recent quarter end the company operated 127 stores in the United States and has indicated the potential for up to 300 in the future. Internationally the company is gradually developing brand presence in places like China, London, and Germany. A handful of members from the management team worked for Starbucks' (NASDAQ:SBUX) international operations before joining LULU. In my opinion, this expertise should play very well in the company's international expansion plan.

Store Count

Growth Rate

Store Increase

2002

5

2003

11

120.00%

6

2004

19

72.73%

8

2005

36

89.47%

17

2006

48

33.33%

12

2007

81

68.75%

33

2008

113

39.51%

32

2009

119

5.31%

6

2010

133

11.76%

14

2011

174

30.83%

41

2012 (projected)

211

21.26%

37

Average

49.30%

20.6

CAGR

45.38%

Source: Lululemon athletica SEC Filings

While some analysts criticize the company for not expanding at a faster pace, it does not appear management is swayed by their suggestions. One of the company's famous quotes is "friends are more important than money". While this may scare some investors, I think it is important in building long-term shareholder value. There have been countless success stories of companies who put their customers first and the profits have quickly followed (See Whole Foods (NASDAQ:WFM) for example).

The e-Commerce based sales for the company are booming as well, growing 89% year over year in the recent quarter. CEO Christine Day also stated in the recent earnings call "We recently launched our Hong Kong, Singapore, U.K. and EU specific websites, which gives us access to 24 markets with local fulfillment, more localized content and the ability to connect more authentically with those communities". This growth in online sales provides a major boost to gross, operating, and net profit margins.

Another major component to growth has been comparable store sales which grew of 18% during the quarter. If e-Commerce was included in this metric it would be reported as 26% growth in same store sales. CFO John Currie noted that fiscal Q4 comps are expected to be "high single digit". These are extremely high comps in the retail sector and speak well for the strength in Lululemon's strategy. The management team and experienced and knowledgeable staff inside each store can likely be credited with assisting in these robust rates.

Cash and Cash Flow From Operations

No one complains when a company generates high levels of cash flow from operations. Fiscal year '09 saw $118 million in cash flow from operations, $180 million in FY10, $203 million in FY11, and $113 million through the first three quarters of FY12 (note FQ4 falls during the holiday season and historically is the best performing quarter for the company). The company has primarily used this cash for reinvestment back into the business by expanding operations, acquiring real estate, and increasing brand awareness. However cash generation has far outweighed capital expenditures. As of the recent quarter end the company had just under $440 million on its balance sheet under cash and cash equivalents.

There is a certain point where too much cash on the balance sheet begins to be a drag on certain performance ratios. Analysts have begun to question management on their intentions of this growing cash pile. CFO John Currie responded to this question during the recent earnings call:

"As I've said in the past, my preference at least, is to get to a point where we've got sufficient cash reserves to fund the most aggressive expansion plan in the midst of a deep recession and can still be comfortable. And then, what I see us doing in the future would be to get to a point where we could institute a regular recurring dividend as opposed to looking at special dividends or buybacks. But it's an ongoing discussion."

In my opinion, an initial step would be to repurchase shares to offset dilution from stock option awards. The table below shows the diluted share count each quarter, although not growing at excessive rates, this is a conservative use of cash by many companies. I don't anticipate a large scale share repurchase program anytime soon for a few reasons. Evaluating this company using a price-to earnings, price-to-sales, price-to-book value, or enterprise value-to-EBITDA ratio (See my recent article for historical valuations) shows Lululemon trading at very high historical price multiples. Management could likely find better investments that trade below 50x earnings.

Fiscal Quarter

Diluted Share Count

Quarterly Growth Rate

Q1 2009

140,662,000

Q2

140,802,000

0.10%

Q3

142,200,000

0.99%

Q4

142,600,000

0.28%

Q1 2010

143,164,000

0.40%

Q2

143,500,000

0.23%

Q3

143,670,000

0.12%

Q4

144,200,000

0.37%

Q1 2011

144,910,000

0.49%

Q2

145,228,000

0.22%

Q3

145,349,000

0.08%

Q4

145,500,000

0.10%

Q1 2012

145,637,000

0.09%

Q2

145,678,000

0.03%

Q3

145,748,000

0.05%

Q4 *

145,900,000

0.10%

Source: Lululemon Athletica SEC Filings

*Management's projection for Q4 diluted share count

In observing Mr. Currie's comments above regarding cash, it is comforting to see that the company wants to build a healthy balance sheet to withstand the possibility of a severe recession. While the particular comfort level of Lululemon management is unknown at this time, one can assume we will reach this level relatively soon. To put the cash flow generation story in perspective, last year during the FQ4 alone, Lululemon generated $150 million in cash flow from operations, the fiscal year prior was $92 million in Q4 alone. Based upon management's estimates for the remaining quarter, and full year 2012 capital expenditures estimated to fall between $85-$90 million, one could assume the cash balance will grown substantially following the fiscal year end.

Conclusion

Lululemon trades at very lofty price multiples, but until the company begins to disappoint investors, it appears the market will continue to award this stock in an appropriate manner. Investors who were willing to short this company have not seen the results they anticipated. I would caution investors who are interested in taking both long and short positions to carefully evaluate the company in greater detail than just my analysis.

Although the effects of Hurricane Sandy, a minor email glitch during the beginning of FQ4, and one less week in the current fiscal year will slightly affect earnings, it appears Lululemon is still going to announce a strong fiscal 2012. CEO Christine Day is already upbeat for the holiday season reporting "accelerated gift card sales" to start the quarter. Management is projecting $1.82 per diluted share on the low end estimate for FY12, a 43% gain year over year.

With 20.7% of the share float being sold short, any positive news or a strong holiday season could result in a major short squeeze. Consider your investment goals and objectives before initiating a position in Lululemon Athletica and remember that the value of investments in equity securities, like LULU, will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. If you see a fit in your portfolio, I think being a long-term shareholder has the potential to provide attractive returns. Although competitors like Nike (NYSE:NKE) and Under Armour (NYSE:UA) are beginning to compete in the yoga apparel space, Lululemon does not appear to be worried. In my opinion, the growth story of this company is still in its early innings.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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